Research Discussion Paper – RDP 2018-01 A Density-based Estimator of Core/Periphery Network Structures: Analysing the Australian Interbank Market Abstract

The market for unsecured overnight interbank loans in Australia is a pivotal financial market; it is the first step in the transmission of monetary policy to the rest of the financial system and broader economy. Understanding the network of relationships between borrowers and lenders in this market, and how it changes during periods of stress, is crucial for understanding the resilience of the market. However, a difficulty with analysing this market is that existing methods of determining which banks are in the core of the network can be highly inaccurate when the network is either highly connected relative to the true proportion of banks in the core, or relatively sparsely connected (a novel finding).

We derive a ‘density-based’ estimator of core/periphery network structures that is designed to overcome these inaccuracies. And we show that our estimator outperforms the commonly used estimators in numerical simulations. These results have broad applicability to the network analysis literature.

We then use our density-based estimator to analyse the Australian overnight interbank market, focusing on the 2007–08 financial crisis. Our results suggest that the crisis had a large and long-lasting effect on this market. In particular, we find that the typical core size fell from eight to five banks during the crisis, because of large reductions in the number of lending relationships between some banks. Compared with the pre-crisis period, the remaining core lent much less to the periphery, while the periphery lent more to the core; these changes are consistent with models of precautionary liquidity demand.